Hedge funds are promising something they probably won't be able to deliver

Boats
of fishermen are seen on the dried Poopo lakebed in the Oruro
Department, south of La Paz, Bolivia.Reuters/David
Mercado

Hedge funds seem to be promising something that is too good to be
true, according to Barclays' capital-solutions group, which
studies this stuff.

Barclays says that since 2008, hedge funds have been shortening
the amount of time it takes for their investors to redeem their
money.

At the same time, however, hedge funds are increasingly in a
position where they can't sell assets quickly to get that money
to return to their investors.

That could spell trouble.

The logical extension of this is that there could be an increase
in redemption suspensions, where funds are overwhelmed with
redemption requests, find that they are unable to sell assets
quickly enough to meet them in the time available to them, and
freeze redemptions.

An example of this came in December. Investment
manager Third Avenue announced plans to
liquidate its high-yield bond mutual fund, and said it would
bar redemptions because it was unable to exit positions
quickly.

That sent shockwaves through the high-yield market, as
other investors worried about their ability to get out of the
market. The resulting sell-off contributed to the rout in
high-yield at the tail end of 2015.

Total redemption time

Barclays' capital-solutions group, which advises hedge funds,
looked at the length of time it took investors to redeem
their money from hedge funds and how that had changed over
the past few years.

According to the group's findings, the total redemption time,
which takes into account the notice period, redemption frequency,
and maximum redemption per period, has come down dramatically
since 2008.

That hedge funds would want to offer better liquidity terms to
investors isn't that surprising. Investors get annoyed when they
want to redeem and find that their money is tied up in a fund.
Offering better liquidity terms is one way to attract investor
interest.

The problem is that those redemption horizons aren't realistic.
The markets in which many of these funds are operating are less
liquid, and that makes it more difficult for funds to sell out of
positions.

Here is Barclays:

If liquidity terms look like they are too good to be true, they
probably are — against a drumbeat of bad news on liquidity in
secondary markets, we think some of the liquidity terms being
offered are pretty unrealistic already (~45% cumulative reduction
in time to redemption across managers we sampled in 2008 versus
now).

The short version of this story is that banks aren't making
markets the way they used to, and so it is harder to find a buyer
for bonds in times of stress. That then leads to prices gapping
out, which adds to the stress. The fear is that this becomes a
self-fulfilling selling cycle, with no one on Wall Street willing
or able to step and set a floor on asset prices.

The Baupost Group, the giant hedge fund led by Seth Klarman,
highlighted this dynamic in the firm's end-of-year
investor letter. Jim Mooney, the head of Baupost's
public investment group, said:

In conversation after conversation, dealers make it clear
that they have neither the balance sheet nor the institutional
mandate to absorb selling pressure.The traditional
"risk" bid from Wall Street trading desks is all but gone.
Further, existing holders frequently have very little appetite
or, often, capacity to add to their holdings. In fact, these
holders frequently are faced with their own pressure to sell into
a declining market in order to satisfy redemptions.

Judging by Barclays' "too good to be true" assessment, it looks
as if there could be more Third Avenue-type events on the
horizon.